Should you use cash accounting? Or, accrual accounting in your business?
And, what’s the difference between cash and accrual accounting anyway?
These are questions that most eCommerce entrepreneurs have at some point.
The answer is it depends on the size of the business, the lens in which you are viewing your financials, and the level of reporting required. In this post, we’re going to discuss each option in more detail:
- What’s cash accounting?
- What are the advantages of cash accounting?
- What’s accrual accounting?
- What are the advantages of accrual accounting?
- Recording Payments in Xero
- When should you switch from cash to accrual accounting?
What’s cash accounting?
Cash accounting, a.k.a. cash basis accounting, is the method most small online businesses use when they start out.
It’s simple to maintain, and there is no need to track accounts receivables or accounts payable. It mirrors the activity that you see across your bank and credit card statements.
With this system, you recognize revenue as soon as the cash is received and expenses as soon as the cash leaves your account.
It’s a real-time system that makes it easy to identify exactly when a transaction happened, and you can see at a glance how much money is in your business on any given day.
What are the advantages of cash accounting?
Here are the key advantages of sticking with cash accounting.
- It is simple – You are tracking cash inflows and outflows as they come in and out of your business. So, you don’t need to worry about complex accounting setups.
- It is present-focused – It is easy to see what your current bank balance and cash position is at any time.
- There are some tax benefits – While this mainly applies to service businesses instead of eCommerce brands, you can have more control over how to account for spikes in either revenue or expenses. For example, you might choose to lower your tax burden by making an expensive purchase in December instead of January.
What’s accrual accounting?
If you choose to use accrual accounting, revenues and expenses are recorded in your financial reporting when they are earned — not when the cash hits or leaves your account.
For example, this could be recognizing Amazon sales in full in December, whereas the cash accounting system would record the revenue sometime in January once you receive the payout.
Accrual accounting is used more commonly by businesses who are growing and need a more robust picture of their financial patterns as it gives a more accurate long-term picture of the revenue and expenses a business incurs over time. It spreads annual costs – such as business insurance – out over the course of the year, which gives you a more accurate picture of the margins you are making on each sale.
What are the advantages of accrual accounting?
There are some key advantages of accrual accounting.
- Regularly have large expenses or inventory purchases – In fact, once you reach a certain threshold (i.e. $25M+ in the U.S), you are legally required to use accrual accounting.
- Receive sales spikes – If you receive a significant chunk of your revenue in bursts throughout the year as a wholesaler and providing credit terms, accrual accounting can work better. For example, if 70% of your revenue occurs during the holiday shopping season, you might want to use accrual accounting.
However, the major downside of accrual accounting is that it does not give you real awareness of your current cash flow. On paper, your business might look extremely successful, when in reality your bank accounts could be empty. If you choose to use the accrual system, you also need to monitor cash flow proactively and plan your future revenue and expense management carefully.
Recording Payments in Xero
Creating a Spend Money Transaction
Cash coding means that when you see a payment on your bank feed in Xero, you use the ‘create’ screen to allocate the payment to an account, for example, ‘advertising’ in the screenshot below
Purchases in Xero
If you are using the purchases area of Xero to enter bills, then when you come to the bank reconcile screen Xero will suggest bill payments that match the bank transaction. It also makes it easier to manage cash flow as you have a list of upcoming bills for payment within Xero.
In the example below, Xero is suggesting a bill from Truxton Property Group (highlighted in green):
So how do I create ‘bills’ in Xero?
- Click Business/Bills to pay
- Click New Bill
- Enter the bill details and attach the vendor invoice
Or, Simply Click the + sign on the right hand side of the top menu bar, then click Bill.
How do you create ‘bills’ in Xero compare?
Creating ‘bills’ in Xero will provide you with better data, cash flow management, and more bill payment automation options, but cash coding is faster.
With a sole trader or small business where the business owner is involved in the day-to-day bookkeeping, cash coding is generally fine. You will still have reasonable reporting in Xero, and it will save time and money.
Once a business grows, and more detailed reporting or cash flow management is required, it is time to start using the bills area of Xero. A business owner should be focusing on high-value tasks like strategy and talking to customers, not entering bills, so this task is best delegated to a team member or outsourced to a bookkeeper.
When should you switch from cash to accrual accounting?
Both methods can be done using Xero.
However, the main difference between cash accounting and accrual accounting comes down to when sales and expenses are recorded in your financial statements.
Neither method is perfect, but it’s important to choose one and stick to it.
While accrual accounting takes more time and skill, it gives you a much more reliable set of financial data that can be used as your business grows. It’s the better choice for businesses who are intending to expand and stay in the game for years to come.
Cash accounting is easy to manage and is probably a better choice for businesses who plan to stay small or who have limited transactions over the course of each year.
Looking for expert advice on which accounting method to use? Schedule a free call.
- The Future of Cloud Accounting and Financial Services - 12 October, 2020
- Xero Accounting: Cash vs. Accrual Accounting – Which Is Better? - 6 October, 2020
- 7 tips to improve your cashflow using Xero - 7 August, 2020